In almost 30 years of being a CPA, I have found partnership taxation to be one of the most complicated areas of taxation, both for other CPA's and for clients. Partnerships involve both inside and outside basis, step-up or down in cost basis for certain transactions and many other compilations that are not there with corporate or individual taxes.
One area that is especially vexing for clients is to understand how their capital accounts. I have found it easier for my clients to view their capital account like a savings account.
When you put money into a savings account, the first initial contribution becomes your balance. The same is true with a capital account. When you first invest in a partnership, the amount of cash (or property) that you put into the partnership becomes your balance.
A savings account with earn interest during the year. A partnership will also have earnings during the year and your share will be allocated your capital account. The beginning amount you put in plus your earnings becomes your new balance.
If you withdraw cash from your savings account, your balance will go down. The same is true with a capital account. If you take cash out of the partnership, your balance will go down.
On some savings plans (such as CD's), if you take your money out early, you will pay a penalty and your account will go down in value. If the partnership losses money, your account will go down by your share of the loss.
Remember, a partnership capital account can go up in two ways:
- You put money or property into the account, or
- You have earnings allocated to you.
Conversely, a partnership capital account can go down in two ways:
- You take money or property out of the account, or
- You have a loss allocated to you.
This is the very simple way of looking at partnership capital accounts, but I think it will allow you to understand how they work.